Concept 3: Margin of Safety

‘As humans, we need to acknowledge the fact that all of us are flawed.’

In one of the previous article, I discussed about ‘intrinsic value’, an estimated figure which varies according to the investor’s perception about a company.

Margin of safety is a concept that accompanies the intrinsic value concept.

For example – An investor may find that stock ‘x’ is currently trading at Rs 130. The intrinsic value of stock ‘x’ is Rs 100 according to his calculations. The margin of safety he would like to maintain is 30%. So, if the price gradually drops to Rs 70, and if he finds nothing suspicious about it, he buys the stock. This allows him to make investments with moderate downside risk.

  • Margin of safety according to Benjamin graham.

Benjamin graham in his book ‘The intelligent investor’ describes margin of safety:  Any investor, bearing in mind the objective of capital preservation, should seek, in all its investments, a reasonable difference between the value it assigns to the business (intrinsic value) and the price it can be bought in order to protect himself in case some unfavorable event happens and to maximize the investment return if the analysis is confirmed.

  • Why is margin of safety so important ?

First, Being wrong is part of the investing process. Intrinsic value estimate calculated by you would be different from the value I calculate. Errors may creep in our calculations. So, it’s more like an insurance policy that helps prevent us from overpaying—it mitigates the damage caused by over-optimistic estimates.

Second, any estimates, at best, are imprecise; at worst, they are completely wrong. Let’s assume that your intrinsic value calculations were 100% right. Still, what about future uncertainties? The future is uncertain. It’s a fact. You need to provide a margin for this uncertainty you face.

Nobody is an exception to this. All the analysts and experts in this world make mistakes and they face uncertainty.  Hence margin of safety is important.

  • What’s the ideal margin of safety?

There is nothing called ‘ideal Margin of safety’. The percentage you would like to maintain depends on how accurate and confident you are with your intrinsic value estimation. If you are confident that your calculations are 100% correct, your margin of safety is 0%.  If you are less confident about your fore­casts, you’ll need a larger margin of safety before buying the shares. Because, there’s simply a greater chance that something might go wrong and that your forecasts are too optimistic.

  • The percentage of margin is your call. I would suggest 25 percent margin of safety for very stable firms with strong competitive advantage to 65 percent for high-risk stocks with no competitive advantages. On aver­age, I suggest a 30 percent to 40 percent margin of safety for most businesses.
  • Price , quality and Margin of safety.

The margin of safety concept makes sure that the price you pay for a stock is closely tied to the quality of the company. Great businesses are worth buying at smaller discounts to fair value. Because, high-quality businesses—those that have wide economic moats—are more likely to increase in value over time. As warren buffet has said, it’s better to pay a fair price for a great business than a great price for a fair business.

CONCLUSION

Having a margin of safety is critical to being a disciplined investor. Investing in the stock market requires some degree of optimism about the future. But that optimism cannot be too much. That results in buying shares at high levels. The margin of safety concept corrects this over- optimism that investors are generally prone to.

Next in line is a concept called ‘risk premium’.

You may like these posts:

  1. 5 Investment concepts
  2. Concept 1: Intrinsic Value.
  3. Concept 2: Book value

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